To decide whether or not to lease your next new car, it's important to understand the financial components. Lease contracts can look very complicated, thanks to their use of bizarre terminology and a host of fees that you may or may not have to pay. It's easy to get confused and pay too much if you don't understand how the various moving parts fit together.

Though you have possession of the car during a lease, it actually belongs to a financial institution, which might be a bank, an automaker's finance arm, or another type of finance company. Once you negotiate a price with the car dealer, the leasing company then buys it from the dealer for that agreed-upon price and leases it to you.

There are five essential elements to a lease contract:

1. Capitalized Cost. Capitalized cost is the agreed-upon price for the car. After deducting for any down payment and/or trade-in (capitalized cost reduction), what's left is the leasing company's actual investment in the car.

2. Residual Value. This is the official estimate of what the car will be worth at the end of a lease term. It's calculated as a percentage of the car's original MSRP (Manufacturer's Suggested Retail Price), then converted to a dollar figure.

3. Money Factor. The money factor—also called the lease rate, lease factor, or factor—is essentially the same as the annual percentage rate (APR) in a conventional loan but is expressed as a small decimal fraction.

4. Term. The term or length of a lease is usually stated in months. A 36-month lease is typical.

5. Mileage Allowance. The mileage allowance is how many miles the lease allows you to travel without penalty. It is usually specified as miles per year, typically 12,000 to 15,000. You can always purchase additional miles during your lease and add them to your payment. But if you sign a contract for high miles and don't use them, you can't get a refund.

Tips for a Smart Lease

With those basic terms and concepts mastered, you will be able to understand the lease deal. And with these following tips, you can make sure it is a good deal.

  • Negotiate the vehicle's purchase price as if you were going to buy the car. Only after you have established a firm price should you discuss a lease deal. And make sure that's the figure used for the lease's gross capitalized cost.
  • The mileage limit, down payment, and purchase-option price can also be negotiated. The more you put down, the less your finance charges will be.
  • Research the money factor in other leases and negotiate it.
  • Unless it's included with the lease, buy GAP (Guaranteed Auto Protection) insurance to protect yourself in case the vehicle is stolen or totaled in an accident.
  • To keep your monthly payments as low as possible, look for cars that don't depreciate faster than average.
  • Avoid leases that extend beyond the car's factory warranty.
  • Note any end-of-lease procedures and fees.
  • Buy extra miles up front if you expect to run over the standard allotment, but don't buy more than you are likely to use.
  • Make sure your trade-in is deducted from the leased car's capitalized cost.
  • If you're considering buying after the lease ends, make sure the vehicle is worth at least as much as its buyout price. If not, try bargaining it down or walk away.